* UK economy contracts 0.2% in Q2, surprising market
* Pound hits as low as $1.2056, 92.885 pence per euro
* Graphic: World FX rates in 2019 http://tmsnrt.rs/2egbfVh
* Graphic: Trade-weighted sterling since Brexit vote http://tmsnrt.rs/2hwV9Hv (Writes through with latest prices)
By Olga Cotaga
LONDON, Aug 9 (Reuters) – Sterling skidded again on Friday, hitting its weakest level since 2017 after an unexpected second quarter contraction in the economy alarmed investors already fretting that Britain is headed for a no-deal Brexit.
The pound, which has lost more than 3% since Prime Minister Boris Johnson’s arrival in office in late July fuelled fears of a disorderly exit from the EU, plunged to $1.2056. That marked a 31-month low.
Against the euro, the pound sank to a two-year low of 92.885 pence, 0.8% down on the day.
Britain’s economy shrank at a quarterly rate of 0.2%, the first contraction since 2012 and below all forecasts in a Reuters poll.
Year-on-year economic growth slid to 1.2% from 1.8% in the first quarter, Britain’s Office for National Statistics said, its weakest since the start of 2018.
British government bond yields fell as investors sought safety in fixed income assets.
UK domestic stocks weakened, although London’s export-heavy blue chip FTSE 100 index clawed its way back into positive territory as sterling weakened.
The pound has suffered a torrid few weeks as investors priced in the growing risk of a no-deal Brexit in October under Johnson. Analysts say there could be more pain to come.
“As the political risk premium rose, GBP was the worst-performing G10 currency in each of May, June and July, but the negative risk premium can still rise further,” RBC Capital Markets analyst Adam Cole said.
Johnson is planning to hold a parliamentary election in the days after Brexit if lawmakers sink the government with a no-confidence vote, British media have reported, further unnerving currency traders.
It is growing increasingly likely that Johnson will face a vote of no confidence soon after Sept. 3, when parliament returns from its summer recess, analysts say.
Johnson says Britain must leave the EU on schedule on Oct. 31, with or without a deal with the bloc. Delaying an election until after Brexit could be a tactic to ensure that happens even if parliament withdraws support for his government.
Vasileios Gkionakis, global head of forex strategy at Lombard Odier, said he was worried about an election. But he also said that he was ready to unload some of the sterling short positions he had accumulated because a lot of bad news had been already priced in.
“If no-deal (Brexit) increases in probability, then of course sterling would be a sell, but until then Iâ€™m becoming a bit more neutral,” Gkionakis said, adding that he expects sterling to “settle around $1.20” before market participants reassess their expectations of that outcome.
The fall in GDP in the second quarter failed to boost investors’ expectations that the Bank of England will cut interest rates in September. Some economists expect the central bank to embark on more easing soon, however.
“As uncertainty continues to loom over the UK economy, the difficult run of data is expected to continue and the BoE will need to consider its next step carefully as its global peers embark on further rate cuts,” said Geoffrey Yu, head of the UK Investment Office at UBS Wealth Management.
Money markets are pricing in a 25 basis point cut by January 2020. (Reporting by Olga Cotaga Additional reporting by Tommy Wilkes; editing by John Stonestreet)